Cost Based Transfer Pricing

This paper compares the performance of alternative cost-based transfer pricing methods. We adopt an incomplete contracting framework with asymmetric information at the trading stage. Transfer pricing guides intra-company trade and provides incentives for value-enhancing specific investments. We compare actual-cost transfer prices that include a markup over marginal costs with standard-cost transfer prices that are determined either by the central office ex-ante (centralized standard-cost transfer pricing) or by the supplying division at the trading stage (reported standard-cost transfer pricing). For the actual-cost methods, we show that markups based on the joint contribution margin (contribution-margin transfer pricing) dominate purely additive markups (cost-plus transfer pricing). We obtain the following results. (i) Centralized standard-cost transfer pricing dominates the other methods if the central office and the divisions ex-ante face low cost uncertainty. (ii) The actual-cost methods dominate the other methods if the central office and the divisions ex-ante face high cost uncertainty and later, at the trading stage, the buying division receives sufficient cost information. (iii) Reported standard-cost transfer pricing dominates the other methods if the central office and the divisions ex-ante face high cost uncertainty, and the buyer has insufficient cost information at the trading stage